One of the strange ideas in the investment world, with knock-on effects to how people and institutions allocate their funds, is the concept of the “risk-free” rate, as mentioned incidentally last week.
That is the rate imputed to government debt stock, and rests on the assumption that a state which ultimately can print its own money cannot default. It accords the status against which all other forms of return and exposure are compared.
Of course, a “buy-and-hold” investor, intending to hold to maturity, can generally expect to be paid in full, given government’s inherent durability in most cases, and its privileges in how it covers its obligations.
But that doesn’t entirely preclude the possibility of default, nor, in particular, does it assure the value of the return, at least when measured in real (inflation-adjusted) terms.
Indeed, it is the overt objective of most economic administrations these days to ensure the persistence of price inflation, so that public sector debt systematically declines as an effective burden, at the expense of those whose payout will be in purely nominal (unadjusted) terms.
To the uninitiated, that makes bonds very much less desirable than they might seem. All that’s supposedly guaranteed is that the original amount represented by the instrument’s par value will be paid out to that sum, albeit in devalued money. In the meantime, whatever yield was stipulated upon issuance can be expected to be delivered throughout the paper’s life.
So where’s the attraction of a sure-fire loss in those circumstances? Essentially, it revolves around the movement of prices (and inversely yield) during trading of the asset’s lifetime, besides an element of certainty about untraded stock’s relative safety.
If market interest rates fall, that particular paper’s worth will rise as its given nominal yield becomes more attractive, and prices respond accordingly. Naturally, the reverse is true as well, meaning that timing the purchase is vital, if there is any intention to sell.
Regulatory authorities
In recent years the rush to the comparative haven of fixed-income products (when set against the radical loss-making capacity of stocks during critical episodes such as the global financial crisis) has exhibited their relative appeal. Again, in absolute terms there is no “risk-free” reality.
Moreover, the weakness of the world economy, lacking inflationary impetus — and especially central banks’ absorption of the state’s deficit-financing bonds with cash printed at will — have driven and underpinned traders’ mentality in a market that is therefore seriously distorted.
In another interventionist manoeuvre, global regulatory authorities are requiring financial institutions to hold more Treasury and similar paper on their books — because of its low designated risk — to ensure against another crisis emanating from that sector!
Of critical concern now, however, is that this artificial boom might soon become a busted flush, particularly as QE ends in the US this month.
If the American recovery is considered genuine enough, then surely inflation will rise and bonds sell off?
Yields on short-dated bonds especially should rise in conjunction with official interest rates, meaning that prices fall. Longer dates involve lesser yield change but greater price reaction, as a natural consequence of the relevant duration of the fixed coupon.
Newcomers to the market, of course, may then step in to take advantage on both counts (prices and yields, which act in tandem either in favour of or against the investor), if they believe the turning tide to be temporary. Others, though, may stay sidelined, reckoning that the much-awaited bear trend is under way.
Meanwhile, a retrenchment in the ultimate “risk-free” paper environment is likely to be harmful to emerging markets (EM), which are intrinsically volatile around the benchmark performance of the US – and it’s here that the discussion switches from the necessary context to the local case.
Phenomenon
Gulf bond and sukuk products have the virtue (as it is currently) of US dollar-related denomination, while the greenback blazes a trail in international foreign exchange. In that particular sense they may be differentiated from many other EM classes. And they have other attributes too.
So, if there is a prospective turn in the US-led interest-rate cycle, how risky is Gulf fixed-income at this point?
Saadaat Yaqub, head of wholesale banking at Noor Bank, Dubai, advised me last week, “This phenomenon is bound to have an impact on the global market, and the Gulf will not remain insulated. [Yet], we feel the effect will be lower than that anticipated in Western markets, mainly on account of the higher liquidity the region has, along with the extra yield that can be extracted from instruments in this region.”
It is noticeable, meantime, that discussion of the growing sukuk market focuses especially on the primary side, namely issuance, with investors intending to hold the paper indefinitely for best effect. The secondary side, namely subsequent trading, is less emphasised. Logically, that may well remain so if bond markets overall have reached a pivotal point.
